Broken BRICs – Can Brazil and Russia rebound?

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Macro Letter – No 35 – 08-05-2015

Broken BRICs – Can Brazil and Russia rebound?

  • The economies of Brazil and Russia will contract in 2015
  • Their divergence with China and India is structural
  • Economic reform is needed to stimulate long term growth
  • Stocks and bonds will continue to benefit from currency depreciation

When Jim O’Neill, then CIO of GSAM, coined the BRIC collective in 2001, to describe the largest of the emerging market economies, each country was growing strongly, however, O’Neill was the first to acknowledge the significant differences between these disparate countries in terms of their character. Since the Great Recession the economic fortunes of each country has been mixed, but, whilst the relative strength of China and India has continued, Brazil and Russia might be accused of imitating Icarus.

Economic Backdrop

In order to evaluate the prospects for Brazil and Russia it is worth reviewing the unique aspects of, and differences between, each economy.

According to the IMF April 2015 WEO, Brazil is ranked eighth largest by GDP and seventh largest by GDP adjusted for purchasing power parity. Russia was ranked tenth and sixth respectively. Between 2000 and 2012 Brazilian economic growth averaged 5%, yet this year, according to the IMF, the economy is forecast to contract by 1%. The forecast for Latin America combined is +0.6%. For Russia the commodity boom helped GDP rise 7% per annum between 2000 and 2008, but with international sanctions continuing to bite, this year’s GDP is expected to be 3.8% lower.

Brazil’s service sector is the largest component of GDP at 67%, followed by the industry,27% and agriculture, 5.5%. The labour force is around 101mln, of which 10% is engaged in agriculture, 19% in industry and 71% in services. Russia by contrast is more reliant on energy and other natural resources. In 2012[update] oil and gas accounted for 16% of GDP, 52% of federal budget revenues and more than 70% of total exports. As of 2012 agriculture accounted for 4.4% of GDP, industry 37.6% and services 58%. The labour force is somewhat smaller at 76mln (2015).

The Harvard Atlas of Economic Complexity 2012 ranks Brazil 56th and Russia 47th. The table below shows the divergence in IMF forecasts since January. During the period October 2014 and February 2015 the Rouble (RUB) declined by 30% whilst the Brazilian Real (BRL) fell only 9%:-

Country GDP GDP Forecast Forecast Jan-14 Jan-14
2013 2014 2015 2016 2015 2016
Brazil 2.7 0.1 -1 1 -1.3 -0.5
Russia 1.3 0.6 -3.8 -1.1 -0.8 -0.1

Source: IMF WEO April 2015

On March 14th the Bank of Russia published its three year economic forecast: it was decidedly rosy. This was how the Peterson Institute – The Incredibly Rosy Forecast of Russia’s Central Bank described it:-

…the Bank of Russia argues that the huge devaluation of the ruble that took place between October 2014 and February 2015 has a minor effect on economic growth. This claim neglects much empirical evidence that sharp devaluations retard investment activity, for two reasons. First, investment technology from abroad becomes more expensive—nearly 80 percent more expensive in the case of Russia. Second, devaluations increase uncertainty in business planning and hence slow down investment in domestic technology as well. Both effects work to depress economic activity in the short term.

…2017 is presented as the year of a strong rebound, as a result of cyclical macroeconomic forces. In particular, says the Bank of Russia, growth will reach 5.5 to 6.3 percent that year. It is true that the economy was already slowing down in 2012, before last year’s sanctions and devaluation. It is also true that the average business cycle globally has historically lasted about six years. But this is no ordinary cycle—sanctions are likely to play a bigger role than the Bank of Russia cares to admit. The main reason is their effect on the banking sector, where credit activity is already substantially curtailed, and may be curtailed even further once corporate eurobonds start coming due later this year. The devaluation has exacerbated the credit crunch as interest rates spiked in early 2015 to over 20 to 25 percent for business loans. These effects point in one direction: a prolonged recession.

Finally, the Russian government is reducing public investment in infrastructure in this year’s budget to try and cut overall expenditure by about 10 percent. This cutback is going to dampen growth because the multiplier on infrastructure investment is highest among all public expenditures. The Bank of Russia seems to have forgotten to account for this elementary fact of life.

Overall, the economic picture may end up being quite different from what the Bank of Russia forecasts. Instead of economic growth of –3.5 to –4 percent in 2015, –1 to –1.6 percent in 2016, and 5.5 to 6.3 percent in 2017, it may be closer to –6 to –7 percent in 2015, –3 to –4 percent in 2016, and zero growth in 2017. This scenario is worth contemplating, as it would mean that the reserve fund that the government uses to finance its deficit may be fully depleted in this period. What then?

The table below compares a range of other indicators for the two economies:-

Indicator Brazil     Russia    
  Last Reference Previous Last Reference Previous
Interest Rate 13.25% Apr-15 12.75 12.50% Apr-15 14
Government Bond 10Y 12.90% May-15 10.71% May-15
Stock Market YTD* 14.70% May-15 23.20% May-15
GDP per capita $5,823 Dec-13 5730 $6,923 Dec-13 6849
Unemployment Rate 6.20% Mar-15 5.9 5.90% Mar-15 5.8
Inflation Rate – Annual 8.13% Mar-15 7.7 16.90% Mar-15 16.7
PPI – Annual 2.27% Jan-15 2.15 13% Mar-15 9.5
Balance of Trade $491mln Apr-15 458 $13,600mln Mar-15 13597
Current Account -$5,736mln Mar-15 -6879 $23,542mln Feb-15 15389
Current Account/GDP -4.17% Dec-14 -3.66 1.56% Dec-13 3.6
External Debt $348bln Nov-14 338 $559bln Feb-15 597
FDI $4,263mln Mar-15 2769 -$1,144mln Aug-14 12131
Capital Flows $7,570mln Feb-15 10826 -$43,071mln Nov-14 -10260
Gold Reserves 67.2t Nov-14 67.2 1,208t Nov-14 1150
Crude Oil Output ,000’s 2,497bpd Dec-14 2358 10,197bpd Dec-14 10173
Government Debt/GDP 58.91% Dec-14 56.8 13.41% Dec-13 12.74
Industrial Production -9.10% Feb-15 -5.2 -0.60% Mar-15 -1.6
Capacity Utilization 79.70% Feb-15 80.9 59.85% Mar-15 62.04
Consumer Confidence** 99 Apr-15 100 -32 Feb-15 -18
Retail Sales YoY -3.10% Feb-15 0.5 -8.70% Mar-15 -7.7
Gasoline Prices $1.04/litre Mar-15 1.16 $0.68/litre Apr-15 0.61
Corporate Tax Rate 34% Jan-14 34 20% Jan-15 20
Income Tax Rate 27.50% Jan-14 27.5 13% Jan-15 13
Sales Tax Rate 19% Jan-14 19 18% Jan-15 18
*Bovespa = Brazil
*Micex = Russia
** Consumer confidence in Brazil – 100 = neutral, Consumer confidence in Russia – 0 = neutral

Source: Trading Economics and Investing.com

From this table it is worth highlighting a number of factors; firstly interest rates. Rates continue to rise in Brazil despite the relatively benign inflation rate. The rise in the Russian, Micex stock index has been much stronger than that of the Brazilian, Bovespa, partly this is due to the larger fall in the value of the RUB and partly due to the recent recovery in the oil price. PPI inflation in Brazil remains broadly benign, especially in comparison with 2014, whilst in Russia it is stubbornly high – making last week’s rate cut all the more surprising.

Brazilian industrial production continues to decline, a trend it has been struggling to reverse, yet capacity utilisation remains relatively high. Russian industrial production never rebounded as swiftly from the 2008 crisis but has remained in positive territory for the last few years despite the geo-political situation. Remembering that one of Russia’s largest industries is arms manufacture – the country ranks third by military expenditure globally behind China and US – this may not be entirely surprising.

Of more concern for Brazil, is the structural nature of its current account deficit, since the advent of the Great Recession. This combination of deficit and inflation prompted Morgan Stanley, back in 2013, to label Brazil one of the “Fragile Five” alone side India, Indonesia, South Africa and Turkey. Russia, by contrast, has run a surplus for almost the entire period since the Asian crisis of 1998.

The Government debt to GDP ratio in Russia has risen slightly but the experience of the Asian crisis appears to have been taken on board. Added to which, the sanctions regime means Russia is cut off from international capital markets. In Brazil the ratio is not high in comparison with many developed nations but the ratio has been rising since 2011 and looks set to match the 2010 high of 60.9 next year if spending is not curtailed.

A final observation concerns gold reserves. Brazil has relatively little, although they did increase in January 2013 after a prolonged period at very low levels. Russia has taken a different approach, since 2008 its reserves have tripled from less than 400t to more than 1,200t today. There have been suggestions that this is a prelude to Russia adopting a “hard currency” standard in the face of continuous debasement of fiat currencies by developed nation central banks, but that is beyond the remit of this essay.

Are the BRICs broken?

In an article published in July 2014 by Bruegal – Is the BRIC rise over? Jim O’Neill discusses the future with reference to the establishment of a joint development bank:-

Some observers believed that the whole notion of a grouping of Brazil, Russia, India and China never made any sound sense because beyond having a lot of people, they didn’t share anything else in common. In particular, two are democracies, and two are not, obviously, China and Russia.  Similarly, two are major commodity producers, Brazil and Russia, the other two, not. And their levels of wealth are quite different, with Brazil and Russia well above $10,000, China around $ 7-8 k, and India less than $ 2k per head.  And the sceptic would follow all of this by saying, the only reason why Brazil and Russia grew so well in the past decade was simply due to a persistent boom in commodity prices, and once that finished, as appears to be the case now, then their economies would lose their shine, as indeed appears to be the case.  Throw in that China would inevitably be caught by its own significant challenges at some point, which the doubters would say, is now, then all is left is India, and if it weren’t for the election of Modi recently, there has not been a lot to justify structural optimism about that country recently.

…I do believe each of Brazil and Russia have got some challenges to face, that they are not yet confronting, which at the core is to reduce their dependency to the commodity cycle, and while there are many differences between them, they do both need to become more competitive and entrepreneurial outside of commodities and to boost private sector investment.

The development has caused much political jawboning but I suspect its impact will be small in the near-term.

Looking again at the figures for capital flows, Brazil appeared to be in better shape, but Russian FDI has been positive in every quarter since 2008 until the most recent outflow in Q3 2014.

Consumer confidence in Brazil has remained more robust, possibly this is due to innate Latin optimism but it may be partly in expectation of the forthcoming Olympics. The games will take place in Rio, reminding us of the high urbanisation rates in Brazil, 85.4%. This is not dissimilar to Russia at 73.9% but substantially higher than China 54.4% and India 32.4%. Interestingly US urbanisation is 81.4% – but US GDP per capita is significantly higher.

Russia

The Peterson Institute – Russia’s Economic Situation Is Worse than It May Appear from early December 2014 painted a gloomy picture of the prospects:-

The Russian economy suffers from three severe blows: ever worsening structural policies, financial sanctions from the West, and a falling oil price. 

…Russia is experiencing large capital outflows, expected to reach $120 billion. Because of Western financial sanctions, they are set to continue. The large outflows erupted in March as investors anticipated financial sanctions, which hit in July and in effect have closed financial markets to Russia. No significant international financial institution dares to take the legal risk of lending Russia money today. 

Not wishing to be left out of the rhetoric on Russia’s demise, in late December the ECFR – What will be the consequences of the Russian currency crisis?:-

The watershed moment was the imposition of the third round of Western sanctions, which cut Russian companies off from the world’s financial markets. Along with falling oil prices (a key market factor), this caused market players to reassess the risks. Before the introduction of sanctions, the ratio of external debt to foreign exchange reserves (at 1.4) was not particularly worrying. But the fact that companies could no longer refinance their debt on external markets necessitated a rethink. It became clear that, with export revenues falling because of lower oil prices, companies would accumulate excess currency in their accounts. The supply of currency in the market from exporters (many of whom also had large debts) declined sharply, while demand from the debtor companies increased.

In October 2014 the Central Bank was forced to spend another $26 billion to support the rouble. After that, preserving the country’s reserves became the priority, so in November, the bank’s intervention fell to $10 billion. So everything was in place for a currency crisis and this is why the Russian Minister for the Economy called it “the perfect storm”. The storm was only halted by a sharp increase in the Central Bank’s interest rate and by informal pressure on companies that brought about a speedy decline in foreign exchange trading.

…So the double devaluation of the rouble will be felt in rising price and shrinking consumption. According to the Gaidar Institute for Economic Policy, this will add at least 10–12 percentage points to normal inflation, which will reach 15-20 percent. Import substitution options are relatively limited: large-scale import substitution would require significant investment and, at the moment, the resources for this are not there. And a fall in consumption (as a result of the falling purchasing power of households) will cause a decline in production.

According to the Central Bank’s December forecast, GDP in 2015 may fall by 4.5–4.8 percent. This is what the bank calls a “stress scenario”, and it assumes that the oil price will stay at $60 a barrel and Western sanctions will remain in place. In fact, this scenario seems to be the most realistic; any other scenario would involve either the lifting of sanctions or a rise in the oil price to $80 or even $100.

The dismal theme was inevitably taken up by CFR – The Russian Crisis: Early Days in early January:-

The most likely trigger for a future crisis resides in the financial sector. December’s $2 billion bailout of Trust Bank, coupled with news of large and potentially open-ended support for VTB Bank and Gazprombank, highlight the rapidly escalating costs of the crisis for the financial sector as state banks and energy companies face high dollar-denominated debt payments and falling revenues. Rising bad loans, falling equity values, and soaring foreign-currency debt are devastating balance sheets. As foreign banks pull back their support, the combination of sanctions, oil prices, and rising nonperforming loans is creating a toxic mix for Russian banks. So far, a crisis has been deferred by the belief that the central bank can and will fully stand behind the banking system. If any doubt creeps in about the strength of that commitment, a run will quickly materialize.

…Sanctions are a force multiplier. Western sanctions have taken away the usual buffers—such as foreign borrowing and expanding trade—that Russia relies on to insulate its economy from an oil shock. Over the past several months, Western banks have cut their relationships and pulled back on lending, creating severe domestic market pressures. The financial system has fragmented. Meanwhile, trade and investment have dropped sharply. These forces limit the capacity of the Russian economy to adjust to any shock. Russia could have weathered an oil shock or sanctions alone, but not both together.

…Measured by the severity of recent market moves, Russia is in crisis. But from a broader perspective, a comprehensive economic and financial crisis would cause a far greater degree of financial distress for the Russian people. Companies would find working capital unavailable; interest rates of 17 percent (or higher) and exchange rate depreciation would cause a spike in import prices; and capital expenditure would crater. All this would generate sharp increases in unemployment and a far greater fall in gross domestic product (GDP) than we have seen so far.

Chatham House – Troubled Times Stagnation, Sanctions and the Prospects for Economic Reform in Russia – published at the end of February, goes into more depth, concluding:-

Over the past three decades, a precipitous drop in oil prices (and a concomitant sharp reduction in rents) has resulted in economic reforms being undertaken in Russia. Mikhail Gorbachev’s perestroika emerged after the fall in oil prices in 1986. Putin’s earlier, more liberal economic policies were carried out after oil dropped to close to $10 a barrel in 1999. And Dmitri Medvedev’s modernization agenda was strongest in the aftermath of the global recession of 2008–09.

Unfortunately, the prospects for a similar surge in economic reform in Russia today are less good. The unfavourable geopolitical environment threatens to change the trajectory of political and economic development in Russia for the worse. By boosting factions within Russia’s policy elite who favour increased state control and less integration with the global economy, poor relations with the West threaten to reduce the prospects for a market-oriented turn in economic policy. As a result, the prevailing system of political economy that is in such urgent need of transformation may in fact be preserved in a more ossified form. Instead of responding to adversity through openness, Russia may take the historically well-trodden path of using a threatening international environment to justify centralization and international isolation in order to strengthen the existing ruling elite.

Thus, while Western sanctions were not necessarily intended to strengthen statist factions within Russia and force the country away from the global economy, this may prove to be an unintended but important outcome. Consequently, Russia appears to be locked into a path of economic policy inertia, as powerful constituencies that benefit from the existing system are strengthened by the showdown with the West. While Russia may have ‘won’ Crimea, and may even succeed in ensuring that Ukraine is not ‘won’ by the West, the price of victory may be a deterioration in long-term prospects for socioeconomic development.

This is how the USDRUB has performed during the last 12 months, the first interest rate cut (from 17% to 15% took place on 30th January, the RUB fell 3% on the day to around USDRUB 70, since then the RUB has appreciated to around USDRUB 55-55:-

USDRUB 1yr

Source: Yahoo Finance

What caused the RUB to return from the brink was a recovery in the oil price and a slight improvement in the politics of the Ukraine. The Minsk II Agreement, whilst only partially observed, has curtailed an escalation of the Ukrainian civil war. Capital outflows which were $77bln in Q4 2014 slowed to $32bln in Q1 2015. Ironically, the rebound in the currency and appreciation in the Micex index will probably delay the necessary structural reforms which are needed to reinvigorate the economy.

Brazil

At the end of February the Economist – Brazil – In a quagmiredescribed the challenges facing President Rousseff’s weak government:-

Brazil’s economy is in a mess, with far bigger problems than the government will admit or investors seem to register. The torpid stagnation into which it fell in 2013 is becoming a full-blown—and probably prolonged—recession, as high inflation squeezes wages and consumers’ debt payments rise (see article). Investment, already down by 8% from a year ago, could fall much further. A vast corruption scandal at Petrobras, the state-controlled oil giant, has ensnared several of the country’s biggest construction firms and paralysed capital spending in swathes of the economy, at least until the prosecutors and auditors have done their work. The real has fallen by 30% against the dollar since May 2013: a necessary shift, but one that adds to the burden of the $40 billion in foreign debt owed by Brazilian companies that falls due this year.

…Ideally, Brazil would offset this fiscal squeeze with looser monetary policy. But because of the country’s hyperinflationary past, as well as more recent mistakes—the Central Bank bent to the president’s will, ignored its inflation target and foolishly slashed its benchmark rate in 2011-12—the room for manoeuvre today is limited. With inflation still above its target, the Central Bank cannot cut its benchmark rate from today’s level of 12.25% without risking further loss of credibility and sapping investor confidence. A fiscal squeeze and high interest rates spell pain for Brazilian firms and households and a slower return to growth.

Yet the president’s weakness is also an opportunity—and for Mr Levy in particular. He is now indispensable. He should build bridges to Mr Cunha, while making it clear that if Congress tries to extract a budgetary price for its support, that will lead to cuts elsewhere. The recovery of fiscal responsibility must be lasting for business confidence and investment to return. But the sooner the fiscal adjustment sticks, the sooner the Central Bank can start cutting interest rates.

More is needed for Brazil to return to rapid and sustained growth. It may be too much to expect Ms Rousseff to overhaul the archaic labour laws that have helped to throttle productivity, but she should at least try to simplify taxes and cut mindless red tape. There are tentative signs that the government will scale back industrial policy and encourage more international trade in what remains an over-protected economy.

Brazil is not the only member of the BRICS quintet of large emerging economies to be in trouble. Russia’s economy, in particular, has been battered by war, sanctions and dependence on oil. For all its problems, Brazil is not in as big a mess as Russia. It has a large and diversified private sector and robust democratic institutions. But its woes go deeper than many realise. The time to put them right is now.

Earlier this week the Peterson Institute – The Rescue of Brazil summed up the current situation:-

The Brazilian economy has all the characteristics of a country under the tutelage of an International Monetary Fund (IMF) program. The list of its economic imbalances is endless: a rampant current account deficit in excess of 4 percent of GDP, an exchange rate that has long been overvalued but that has collapsed in just a few months, a public debt ratio to GDP in a rapid upward trend, a fiscal deficit of over 6 percent of GDP despite a high tax burden, an annual inflation rate of nearly 8 percent that has unanchored inflation expectations, an accelerated growth of wages well above their very low productivity. The scandal of the oil company Petrobras, the latest in a long series of political corruption scandals, is the straw that could break the back of investors’ patience, the tolerance of Brazilian citizens, and the stamina of the world’s seventh largest economy. The Petrobras scandal has far-reaching ramifications throughout the economy and society, paralyzing activity and collapsing both business and consumer confidence to unprecedented levels. The mass street demonstrations of recent weeks are the most graphic example of this dissatisfaction.

In another Op-ed Peterson – Brazil’s Investment: A Maze in One’s Own Navel the authors point to the relatively closed nature of the Brazilian economy for the lack of international investment:-

Consider the most common explanations for why Brazil’s investment rate shows persistent apathy: Excessive taxes levied on businesses discourage fixed capital formation; poor infrastructure—including ongoing problems in the energy sector—increases production costs; high wages relative to worker productivity weigh on firms, hampering investment; an opaque business environment characterized by obsolete and excessive licensing requirements reduce firms’ incentives to invest; an institutional environment marked by subsidized lending that favors certain firms over others misallocates scarce domestic savings; “state capitalism” and excessive government intervention crowd out the private sector. Evidently, all of these reasons have a role in explaining investment inertia. But, importantly, they are all homegrown.

Perhaps Brazil’s sclerotic investment has something to do with its long-standing lack of openness. It is no mystery that Brazil is one of the most closed economies in the world according to any metric that one chooses to gauge the degree of openness. It is no coincidence that this is also the most striking difference between Brazil and its emerging-market peers: Brazil is more closed than Mexico, Colombia, Peru, and Chile; all members of the Pacific Alliance, their growth rates are higher than Brazil’s. Brazil is also less open than India, China, Turkey, and South Africa.

There is an extensive academic and empirical literature on the relationship between investment and openness (see, for example, the Peterson Institute’s video on trade and investment). Several research papers show that the more open an economy is to international trade, the more foreign direct investment it receives. The more foreign direct investment it receives, the greater the availability of resources for domestic investment. Competition is also crucial: Economies that are more open induce greater competition between local and foreign firms, creating incentives for innovation and investment by domestic companies.

Unfortunately, Brazil is still fairly close-minded when it comes to these issues. Fears of losing market share and the old litany of “selling the country to foreigners” still dominate the national debate.

The weakening of the BRL has continued for rather longer than the decline in the RUB, perhaps as a result of the Petrobras “Car Wash” scandal, but a modicum of stability has been regained since early April, as the chart below shows:-

USDBRL 1yr

Source: Yahoo Finance

Commodity correlation

Both Brazil and Russia are large commodity exporters. The table below is for 2011 but a clear picture emerges:-

Commodity Russia Brazil
Oil & Products $190bln $22bln
Iron Ore & Products $19bln $54bln

Source: CIA Factbook

Platts reported that Iron Ore prices (62% Fe Iron Ore Index) had risen since the end of April to $57.75/dmt CFR North China, up $2.25 on 4th May. It is probably too soon to confirm that Iron Ore prices have bottomed but with oil prices now significantly higher ($60/bbl) since their lows ($45/bbl) seen in March. Copper has also begun to rise – perhaps in response to the performance of the Chinese stock market – rising from lows of less than $2.50/lb in January to $2.94/lb this week.

The chart below shows the relative performance of the CRB Index and the GSCI Index which has a heavier weighting to energy:-

GSCI and CRB 1 yr

Source: FT

The general recovery in commodity prices is still nascent but it is supportive for both Brazil and Russia in the near term. Both countries have benefitted from devaluation relative to their export partners as this table illustrates:-

Russia Exports Brazil Exports
Netherlands 10.70% China 17%
Germany 8.20% United States 11.10%
China 6.80% Argentina 7.40%
Italy 5.50% Netherlands 6.20%
Ukraine 5%
Turkey 4.90%
Belarus 4.10%
Japan 4.00%

Source: CIA Factbook

Asset prices and investment opportunities

Real Estate

Russian real estate prices have been subdued during the last few years, but the underlying market has been active. The lack of price appreciation is due to a massive increase in house building. 912,000 new homes were built in 2013 – the highest number since 1989. Prices are lower in 10 out 46 regions, however, this new supply should be viewed in the context of the housing bubble which drove prices higher by 436% between 2000 and 2007:-

russia-house-prices-2

Source: Global Property Guide

Brazilian property, by contrast, has risen in price. In inflation adjusted terms, prices increased 7.6% in 2013, although these increases are less than those seen during 2011/2012. Rio continues to outperform (+15.2% vs +13.9% nationally) and the forthcoming Olympics should support prices into 2016:-

brazil-house-prices-1

Source: Global Property Guide

Neither of these markets present obvious opportunities. Brazilian prices are likely to moderate in response to higher interest rates whilst increased Russian supply will hang over the market for the foreseeable future. The rental yields in the table are somewhat out of date but clearly offer a less attractive income than government bonds:-

BRAZIL November 16th 2013
SAO PAULO – Apartments
Property Size Yield
80 sq. m. 5.68%
120 sq. m. 4.71%
200 sq. m. 6.15%
350 sq. m. 6.23%
RIO DE JANEIRO -Apartments
60 sq. m. 4.40%
90 sq. m. 3.82%
120 sq. m. 3.91%
200 sq. m. 4.89%
RUSSIA June 24th 2014
MOSCOW – Apartments
Property Size Yield
75 sq. m. 3.84%
120 sq. m. 3.22%
160 sq. m. 3.07%
275 sq. m. 3.42%
ST. PETERSBURG – Apartments
60 sq. m. 6.20%
120 sq. m. 4.36%
175 sq. m. 3.46%

Source: Global Property Guide

Stocks

The chart below compares the performance of Micex and the Bovespa indices over the past year. The devaluation of the RUB has been greater than that of the BRL – this accounts for the majority of the divergence:-

MICEX vs BOVESPA 1yr

Source: FT

Looking more closely at the components of the two indices there is a marked energy and commodity bias, the table below looks at the largest stocks, representing roughly 80% of each index:-

Ticker Stock Weight Sector Free-float
GAZP GAZPROM 15 Energy 46%
SBER Sberbank 14.01 Financial Services 48%
LKOH ОАО “LUKOIL” 13.97 Energy 57%
ROSN Rosneft 5.84 Energy 15%
URKA Uralkali 5.19 Commodity 45%
GMKN “OJSC “MMC “NORILSK NICKEL” 4.79 Commodity 24%
NVTK JSC “NOVATEK” 3.93 Energy 18%
SNGS Surgutneftegas 3.49 Energy 25%
RTKM Rostelecom 3.03 Telecomm 43%
TATN TATNEFT 3.01 Energy 32%
VTBR JSC VTB Bank 2.97 Financial Services 25%
MGNT OJSC “Magnit” 2.22 Commodity 24%
TRNFP Transneft, Pref 2.21 Energy 100%
TOTAL WEIGHTING 79.66
Ticker Stock Weight Sector
ITUB4 ITAUUNIBANCO 10.764 Financial Services
BBDC4 BRADESCO 8.2 Financial Services
ABEV3 AMBEV S/A 7.368 Brewing
PETR4 PETROBRAS 6.045 Energy
PETR3 PETROBRAS 4.416 Energy
VALE5 VALE 3.971 Commodity
BRFS3 BRF SA 3.741 Commodity
VALE3 VALE 3.558 Commodity
ITSA4 ITAUSA 3.433 Financial Services
CIEL3 CIELO 3.37 Financial Services
JBSS3 JBS 2.705 Commodity
UGPA3 ULTRAPAR 2.487 Energy
BBSE3 BBSEGURIDADE 2.47 Financial Services
BVMF3 BMFBOVESPA 2.393 Financial Services
BBAS3 BRASIL 2.344 Financial Services
EMBR3 EMBRAER 1.823 Aerospace
VIVT4 TELEF BRASIL 1.733 Telecomm
PCAR4 P.ACUCAR-CBD 1.663 Retail
KROT3 KROTON 1.49 Support Services
CCRO3 CCR SA 1.48 Transport
BBDC3 BRADESCO 1.445 Financial Services
LREN3 LOJAS RENNER 1.364 Retail
CMIG4 CEMIG 1.207 Energy
CRUZ3 SOUZA CRUZ 1.027 Tobacco
TOTAL WEIGHTING 80.497

Source: Moscow Exchange and BMF Bovespa

The Russian index is clearly more exposed to energy, 48% and commodities, 12%, than the Brazilian index, where the weightings are 14 % each for energy and commodities. It is important to note that the Bovespa index adjusts for the “free-float” for each stock whilst Micex does not, however under Micex rules no stock may account for more than 15% of the index. The free-float adjusted weight of energy and commodities is therefore 18% and 4% respectively.

On the basis of this analysis, currency fluctuation has been the predominant influence on stock market returns, followed by energy and commodity prices. The PE ratios of Micex and Bovespa at roughly 8 times, are undemanding but neither the economic nor the political situation in either country is conducive to long term growth. I expect both markets to continue to recover, although Micex will probably fair best. Longer term, economic reform is required to raise the structural rate of growth.

Although not mentioned in any of the articles quoted above, Russian demographics are unfavourable as this article from Yale University – Russian Demographics: The Perfect Storm – makes clear:-

One measure of an economically secure homeland is women’s willingness to raise children with the expectation of opportunities for good health, education and livelihoods. On that front, Russia confronts a perfect storm – as fertility rates plummeted to 1.2 births per women in the late 1990s and now stand at 1.7 births per women. “Russia’s population will most likely decline in the coming decades, perhaps reaching an eventual size in 2100 that’s similar to its 1950 level of around 100 million,” write demographers Joseph Chamie and Barry Mirkin. The country has high mortality rates due to elevated rates of smoking, alcohol consumption and obesity. Investment on healthcare is low. Over the next decade, Russia’s labor force is expected to shrink by about 15 percent. Other countries with low fertility rates turn to immigration to pick up the slack. While immigrants make up about 8 percent of Russia’s population, the nation has a reputation for nationalism and xenophobia, and fertility rates are even lower in neighboring Belarus, Ukraine and Lithuania, all possible sources of immigration.

Brazil has better demographic prospects in the near term, but its population growth is now not much above the world average and by 2050 it too will be entering a demographic “Götterdämmerung” of declining population. A freer, more open economy is the most efficient method of deflecting the effects of the long term demographic deficits – stock markets reflect this in their risk premiums.

Bonds

Brazilian government bonds offer a real return after adjusting for inflation (10 yr real-yield 4.77%) however, as this March 2015 article from Forbes – With Currency In Gutter And Bad News Galore, Brazil Bonds A Buy makes clear, there are significant risks:-

…the major headwinds against Brazil are domestic. The fact that China is slowing down is no longer a fright factor. What keeps investors up at night is the possibility of Brazil losing its investment grade.  But last month, Standard & Poor’s credit analysts were in Brasilia and left saying that a downgrade to junk was unlikely.

There is the risk of impeachment and the resignation of Finance Minister Joaquim Levy, but that is already priced into the market with local interest rate futures trading over 14.35% compared to the actual benchmark rate of 12.75%.  Moreover, the impeachment of Dilma Rousseff and the resignation of Levy are worse case scenarios with low probabilities. Worries over energy rationing have subsided.

I believe Brazilian bonds offer good value, even at these levels, the central banks has taken a draconian approach to inflation and the BRL has recovered some of the ground it lost during the last year. Exports to the US should improve and signs of a recovery in European growth will benefit the BRL further.

Russian government bonds look less compelling – with headline inflation at 16.9% and 10 yr yields of only 10.71% one might be inclined to avoid them on the grounds on negative real yield – but a case can be made for lower inflation and a resurgence in the value of the RUB as this article from RT – Russia’s ‘junk’ bonds paying off handsomely suggests:-

“It’s very simple advice. Bonds are much more attractive than a year ago. Risks related to the ruble have subsided, inflation is likely to moderate, the BoP (Balance of Payments) and budget situation look reasonably strong and that is why the outlook is quite favorable,” Vladimir Kolychev, Chief Economist for Russia at VTB Capital

“Unless geopolitics interferes, we forecast Russian rates are likely to repeat Hungary’s three-year bull market run in the years ahead,” Bank of America’s head of emerging EMEA economics David Hauner

In a March 11 note, Russia’s Goldman Sachs analysts wrote “Russian bonds are both cyclically and structurally under-priced,” in a big part due devaluation expectations of the ruble stabilizing.

I remain less convinced about the value of Russian bonds but with a low debt to GDP ratio they may perform well.

Here are the recent price charts for 10 year maturities:-

russia-government-bond-yield

Source: Trading Economics

brazil-government-bond-yield

Source: Trading Economics

As inflation declines in both countries their bond markets will continue to rise in expectation of further central bank rate cuts. This will also support stocks but bonds will lead the rally, especially if future growth in Brazil or Russia should disappoint.

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Commodity super-cycles in a fiat currency world

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Macro Letter – No 2 – 16-12-2013  

Commodity super-cycles in a fiat currency world

Notwithstanding weakness in the last six weeks, stock markets have witnessed significant gains during 2013, but commodities – with a few exceptions – have failed to follow suit.

For global investors the advent of investible commodity indices has simplified the commodity allocation process but I have always encouraged my readers to view each commodity on its own merits.

The Goldman Sachs – GSCI Index is constructed on a production weighted basis; the table below is courtesy of Reuters: –

                       2013       2012    Change Vs 2012

 WTI Crude           30.96%     24.71%           6.25%

 Kansas Wheat         0.88%      0.68%           0.20%

 Live Cattle          2.71%      2.62%           0.09%

 Sugar                1.90%      1.85%           0.05%

 Cotton               1.12%      1.07%           0.05%

 Gold                 3.05%      3.00%           0.05%

 Soybeans             2.63%      2.62%           0.01%

 Coffee               0.83%      0.82%           0.01%

 Natural Gas          2.03%      2.02%           0.01%

 Zinc                 0.52%      0.51%           0.01%

 Cocoa                0.23%      0.23%           0.00%

 Nickel               0.58%      0.58%           0.00%

 Silver               0.49%      0.49%           0.00%

 Aluminum             2.12%      2.13%          -0.01%

 Lead                 0.38%      0.40%          -0.02%

 Corn                 4.66%      4.69%          -0.03%

 Feeder Cattle        0.49%      0.52%          -0.03%

 LME Copper           3.24%      3.28%          -0.04%

 Lean Hogs            1.52%      1.58%          -0.06%

 Chicago Wheat        3.04%      3.22%          -0.18%

 Gas Oil              8.11%      8.56%          -0.45%

 RBOB Gasoline        5.02%      5.90%          -0.88%

 Heating Oil          5.13%      6.17%          -1.04%

 Brent Crude         18.35%     22.34%          -3.99%

This highlights the increasing production of WTI Crude (West Texas Intermediate) relative to Brent Crude. It also highlights the substantial index weighting to Energy followed by Metals and then Grains. In this letter I will keep these weightings in mind.

The table below, from barchart.com, shows the year to date performance of the major US futures markets. The price divergence is not atypical.

US Futures YTD - barchart

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Source: barchart.com

As an “asset class” commodities offer among the most uncorrelated returns, but, unlike more traditional assets, they generally have a negative real expected long-term return. In other words, due to human ingenuity, the cost of production falls over time.

Back in 2006 I used the chart below from the Economist as part of a presentation about the dangers of “long-only” investment in commodities. The Economist first published its Industrial Commodity-price index in 1864 due to demand for information on commodity markets resulting from the strong price appreciation during the preceding two decades. The commodity price appreciation was driven primarily by US demand as the country industrialised and then entered into a bloody civil war. Historic data was collected to create a starting level of 100 in 1845. When the raw data is deflated using the US GDP deflator you will observe that the current index is rebounding from a cyclical low of 20.

The Economist industrial commodity-price index

Economist Commodity Price Index - deflated - 1845 - 2005.

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Source: Economist

Today, in a world of fiat currencies, it is more difficult to examine the cause and effect of changes in supply and demand for commodities because their measurement – generally in US$ – is itself a “moving target” rather than a “store of value”. However, given the vagaries of Gold leasing and the plethora of conspiracy theories surrounding the price of Gold, the “gently declining” US$ seems like the most familiar measure of value. This “Dollar Value” is practical in the short-term but in the Long Run the entire commodity cycle may be as much a reflection of monetary policy as supply and demand for the underlying commodities.

The collapse of Bretton Woods in 1971 heralded in a period of inflation, the appointment of Paul Volcker as governor of the Federal Reserve finally reversed this process as he attempted to control the supply of money. The bursting of the “Tech Bubble” and a policy of low interest rates created the conditions for the next “Super-cycle”.

One of the vexing issues with commodity super-cycles is their variability of duration. This paper from the United Nations Department of Economic and Social Affairs – Super-cycles of commodity prices since the mid-nineteenth century – is a useful guide to the difficulties of prediction: –

http://www.un.org/esa/desa/papers/2012/wp110_2012.pdf

Here is the abstract:-

Decomposition of real commodity prices suggests four super-cycles during 1865-2009 ranging be­tween 30-40 years with amplitudes 20-40 percent higher or lower than the long-run trend. Non-oil price super-cycles follow world GDP, indicating they are essentially demand-determined; causality runs in the opposite direction for oil prices. The mean of each super-cycle of non-oil commodities is generally lower than for the previous cycle, supporting the Prebisch-Singer hypothesis. Tropical agriculture experienced the strongest and steepest long-term downward trend through the twentieth century, followed by non-tropical agriculture and metals, while real oil prices experienced a long-term upward trend, interrupted temporarily during the twentieth century.

The paper goes on to point out that these cycles can last between 20 and 70 years. The UN, however, focus on developing country demand, seeing it as the main driver of the cycles; they don’t consider the “money” side of this phenomenon.

The origin of modern economic studies of cycles is thought to have commenced with Nicolai Kondratiev, it was then taken up by economists of the Austrian School, most notably Joseph Schumpter. At this time – 1930’s – other price cycle theories were being developed independently by Ralph Elliott, among others. Elliott’s ideas were published in his book – The Wave Principle – in 1938. Among his influences were the Italian 10th Century mathematician Leonardo of Pisa – otherwise known as Fibonacci.

I believe there is another long-term factor which drives these cycles, beyond economic growth and currency debasement, and that is geopolitical tension. In developing my thoughts on this subject I am indebted to two authors; Marc Widdowson – The Coming Dark Age – The Phoenix Principle – which I must admit I am still reading, you may download it here: –

http://www.scribd.com/doc/63914376/The-Coming-Dark-Age

The other author is David Murrin – Breaking the Code of History – David looks at the history of empires using a wave principle derived from Elliott and the Polish-American mathematician Benoit Mandelbrot’s theories of fractal geometry, here is his website:-

www.davidmurrin.co.uk

In simple terms, David’s observation is that the majority of wars, throughout history, have been driven by resource scarcity. Looking back at the Economist Commodity Price Index you can identify the great conflicts of recent history. However, during the tumults, more often than not, payment in specie was suspended and inflation ensued. Any countries return to the “Gold Standard”, or its equivalent, was likely to precipitate an inevitable period of deflation; as happened to the UK and US after the first world war.

Returning to the factor of debasement, during the “Great Deformation”, as David Stockman describes the post Bretton Woods era (1971 onwards) governments have been operating in an elastic “quasi-war finance” environment. When ever a crisis arrives, governments lean on their respective central banks to backstop the markets with abundant liquidity. As the worlds’ “reserve currency” is the US$, the US government has an advantage – what De Gaulle referred to as the “exorbitant privilege” during the period of the gold exchange standard, remains a  boon today – but other countries have succeeded to a lesser degree by allowing their currencies to decline relative to the UD$.

The prospects for commodities

Looking ahead to 2014 there are a plethora of factors to consider. I will focus on just a few: –

Commodity – Demand

On the demand side of the equation are China followed by other emerging market countries where strong economic growth is expected. Below is the OECD GDP forecast from 20th November 2013: –

Real   gross domestic product – forecasts
‌‌

‌2008‌

‌2009‌

‌2010‌

‌2011‌

‌2012‌

‌2013‌

‌2014‌

‌2015‌

Australia

2.4

 

1.5

 

2.6

 

2.4

 

3.7

 

2.5

 

2.6

 

3.1

 

Austria

0.9

 

-3.5

 

1.9

 

2.9

 

0.6

 

0.4

 

1.7

 

2.2

 

Belgium

1.0

 

-2.8

 

2.4

 

1.9

 

-0.3

 

0.1

 

1.1

 

1.5

 

Canada

1.2

 

-2.7

 

3.4

 

2.5

 

1.7

 

1.7

 

2.3

 

2.6

 

Chile

3.2

 

-0.9

 

5.7

 

5.8

 

5.6

 

4.2

 

4.5

 

4.9

 

Czech   Republic

3.1

 

-4.5

 

2.5

 

1.8

 

-1.0

 

-1.5

 

1.1

 

2.3

 

Denmark

-0.8

 

-5.7

 

1.4

 

1.1

 

-0.4

 

0.3

 

1.6

 

1.9

 

Estonia

-4.2

 

-14.1

 

2.6

 

9.6

 

3.9

 

1.0

 

2.4

 

4.0

 

Finland

0.3

 

-8.5

 

3.4

 

2.7

 

-0.8

 

-1.0

 

1.3

 

1.9

 

France

-0.2

 

-3.1

 

1.6

 

2.0

 

0.0

 

0.2

 

1.0

 

1.6

 

Germany

0.8

 

-5.1

 

3.9

 

3.4

 

0.9

 

0.5

 

1.7

 

2.0

 

Greece

-0.2

 

-3.1

 

-4.9

 

-7.1

 

-6.4

 

-3.5

 

-0.4

 

1.8

 

‌‌

‌2008‌

‌2009‌

‌2010‌

‌2011‌

‌2012‌

‌2013‌

‌2014‌

‌2015‌

Hungary

0.9

 

-6.8

 

1.1

 

1.6

 

-1.7

 

1.2

 

2.0

 

1.7

 

Iceland

1.2

 

-6.6

 

-4.1

 

2.7

 

1.4

 

1.8

 

2.7

 

2.8

 

Ireland

-2.2

 

-6.4

 

-1.1

 

2.2

 

0.1

 

0.1

 

1.9

 

2.2

 

Israel 1

4.5

 

1.2

 

5.7

 

4.6

 

3.4

 

3.7

 

3.4

 

3.5

 

Italy

-1.2

 

-5.5

 

1.7

 

0.6

 

-2.6

 

-1.9

 

0.6

 

1.4

 

Japan

-1.0

 

-5.5

 

4.7

 

-0.6

 

1.9

 

1.8

 

1.5

 

1.0

 

Korea

2.3

 

0.3

 

6.3

 

3.7

 

2.0

 

2.7

 

3.8

 

4.0

 

Luxembourg

-0.7

 

-5.6

 

3.1

 

1.9

 

-0.2

 

1.8

 

2.3

 

2.3

 

Mexico

1.2

 

-4.5

 

5.1

 

4.0

 

3.6

 

1.2

 

3.8

 

4.2

 

Netherlands

1.8

 

-3.7

 

1.5

 

0.9

 

-1.2

 

-1.1

 

-0.1

 

0.9

 

New   Zealand

-0.6

 

0.3

 

0.9

 

1.3

 

3.2

 

2.3

 

3.3

 

2.9

 

Norway

0.1

 

-1.6

 

0.5

 

1.2

 

3.1

 

1.2

 

2.8

 

3.1

 

Poland

5.0

 

1.6

 

3.9

 

4.5

 

2.1

 

1.4

 

2.7

 

3.3

 

Portugal

0.0

 

-2.9

 

1.9

 

-1.3

 

-3.2

 

-1.7

 

0.4

 

1.1

 

Slovak   Republic

5.8

 

-4.9

 

4.4

 

3.0

 

1.8

 

0.8

 

1.9

 

2.9

 

Slovenia

3.4

 

-7.9

 

1.3

 

0.7

 

-2.5

 

-2.3

 

-0.9

 

0.6

 

Spain

0.9 

-3.8

 

-0.2

 

0.1

 

-1.6

 

-1.3

 

0.5

 

1.0

 

‌‌

‌2008‌

‌2009‌

‌2010‌

‌2011‌

‌2012‌

‌2013‌

‌2014‌

‌2015‌

Sweden

-0.8

 

-5.0

 

6.3

 

3.0

 

1.3

 

0.7

 

2.3

 

3.0

 

Switzerland

2.2

 

-1.9

 

3.0

 

1.8

 

1.0

 

1.9

 

2.2

 

2.7

 

Turkey

0.7

 

-4.8

 

9.2

 

8.8

 

2.2

 

3.6

 

3.8

 

4.1

 

United   Kingdom

-0.8

 

-5.2

 

1.7

 

1.1

 

0.1

 

1.4

 

2.4

 

2.5

 

United   States

-0.3

 

-2.8

 

2.5

 

1.8

 

2.8

 

1.7

 

2.9

 

3.4

 

Euro   area (15 countries)

0.2

 

-4.4

 

1.9

 

1.6

 

-0.6

 

-0.4

 

1.0

 

1.6

 

OECD-Total

0.2

 

-3.5

 

3.0

 

1.9

 

1.6

 

1.2

 

2.3

 

2.7

 

Brazil

5.2

 

-0.3

 

7.5

 

2.7

 

0.9

 

2.5

 

2.2

 

2.5

 

China

9.6

 

9.2

 

10.4

 

9.3

 

7.7

 

7.7

 

8.2

 

7.5

 

India

6.2

 

5.0

 

11.2

 

7.7

 

3.8

 

3.0

 

4.7

 

5.7

 

Indonesia

6.0

 

4.6

 

6.2

 

6.5

 

6.2

 

5.2

 

5.6

 

5.7

 

Russian   Federation

5.2

 

-7.8

 

4.5

 

4.3

 

3.4

 

1.5

 

2.3

 

2.9

 

South   Africa

3.6

 

-1.5

 

3.1

 

3.5

 

2.5

 

2.1

 

3.0

 

3.7

 

Source: OECD

Resource security has influenced China’s foreign policy for several years. Their increasing presence in Africa is but one example of this approach. Chinese trade negotiations at a bilateral and multilateral level continue apace. China’s latest economic policies are discussed by Jamestown Foundation – Economic Reform in the Third Plenum: Balancing State and Market –  

http://www.jamestown.org/programs/chinabrief/single/?tx_ttnews%5Btt_news%5D=41667&tx_ttnews%5BbackPid%5D=25&cHash=9fc3fb92316d1e463d72d5505fc20884#.UqrHhJRFDMx

The new “market-centric” policy suggests more, rather than less, uncertainty for commodity prices: –

The plenum report calls for the market to play a “decisive role” (juedingxing zuoyong) in the allocation of resources in the economy. This represents an elevation from previous party documents, which assigned the market a “fundamental role” (jichuxing zuoyong) in resource allocation. This change in language reflects a step forward in the continued reduction in the number of official price controls. Areas that are specifically targeted in the report include the prices of water, oil, natural gas, electricity, transportation and information technology.

As the private sector gains traction and State Owned Enterprises (SOEs) diminish, better inventory controls are bound to be implemented. Chinese stockpiles of commodities have been a function of SOEs ability to purchase well into the future. The more cash-flow constrained private sector will need to operate more efficiently and with lower stock levels. During the transition I anticipate some reduction in demand. In the past year a moderate slow-down in Chinese growth, combined with a backing-up of US Treasury yields in anticipation of the tapering of QE has put significant downward pressure on a broad array of industrial commodities. With stronger growth forecast for next year demand may lead to an increase in prices but the structural rebalancing towards the private sector is a strong counter-factor.

Energy – supply

On the supply side, starting with Oil, Gas and Coal are the OPEC members, Russia and USA – though it is worth noting that China is the fifth largest Oil producer. Recent price action in Crude Oil has been puzzling in that the price rallied following the recent Iranian peace deal. The European Council for Foreign Relations – The Gulf and sectarianism – give some insight into the increased risk that the recent agreement has created, however, it goes on to look at Shiite/Sunni tensions throughout the whole middle eastern region: –

No single country is considered to do more to propagate sectarianism than Saudi Arabia. As Andrew Hammond writes in his essay in this issue of Gulf Analysis, the Saudi royal family sees itself as the rightful inheritor and guardian of Islamic orthodoxy. Saudi Arabia’s formal interpretation of Islam is ideologically sectarian, condemning all other traditional schools of Islamic thought and religious communities as heresy. The state and private citizens put millions every year into evangelism (known in Arabic as da’wa), the establishment of schools and mosques worldwide and financial support to print and broadcast media that promote its interpretation of Islam.

As Shiite communities inside Saudi Arabia and around it constitute the largest and most organised group of such “heretics”, it deliberately subjects them to particularly stringent criticism and discrimination. Even before the Arab Awakening, the rise of an Islamist, Shiite Iran, and then a Shiite Iraq had already posed a serious threat to a Saudi and Wahhabi influence over the region.

The full article can be found here: –

http://ecfr.eu/page/-/ECFR91_GULF_ANALYSIS_AW.pdf

The oil price appears to be trapped in a virtuous/vicious circle: a collapse in the oil price will exacerbate sectarian tensions prompting a rise in the price of oil. Only a significant slowdown in global demand is likely to change this dynamic.

Of course, there are other geopolitical flashpoints; Russia – as they approach the winter Olympics – the South China Sea (as discussed last week) but the disruption to energy supplies created by a new Middle Eastern conflict would probably cause the largest immediate damage to global growth.  Returning to the UN paper, the “Oil Cycle” tends to be “contra” to other commodities; rising oil prices are often referred to as a tax on consumption. It may also go some way to explaining the relatively strong performance of oil in 2013 despite significant increases in fracking production and continuous improvement in drilling techniques. The chart below shows the relative strength of oil since the Great Recession began.

WTI - 5 yr chart - infomine

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Source: infomine.com

Natural Gas in the US is a “local” market due to US restrictions on the issue of export licenses and the significant cost of gas liquefaction. In Europe, Russia is the dominant player. Russian gas prices have been relatively stable this year, although they have rebounded more strongly than US Natural Gas since 2008.

The recent surge in US gas prices is a response to regional weather conditions. It’s worth noting that US Natural Gas prices tend to be either non or negatively correlated to the price of WTI. Overall supply is increasing and as the government issues more LNG licenses – longer-term I expect prices to remain subdued.

US Natural Gas - 5 yr chart - infomine US Natural Gas - 6 month chart - source infomine

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Source: infomine.com

Coal has remained subdued in the US and elsewhere during 2013. China is the largest producer followed by the US, India, Australia and Russia. Thermal Coal has rallied recently in response to the spike in Natural Gas but, barring a significant increase in global demand, I don’t envisage a marked increase in prices in 2014.

US Thermal Coal CAPP - 2001 to 2013 - Source Infomine

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Source: infomine.com

Industrial metals – Supply

Among the industrial metals I will focus on Iron Ore/Steel and Copper. These form the basis for a large swathe of industrial activity. The largest producers of Iron Ore are China, Australia, Brazil, India and Russia. By contrast global copper production is dominated by Chile which produces around 5 mln tons (USA is next with just over 1 mln tons).

Iron Ore - 5yr chart - source infomine Copper - 24 yr chart - source infomine

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Source: infomine.com

Iron Ore has reflected the moribund state of global demand since the start of the great recession. Copper has recovered from its 2009 lows but further upside impetus is lacking. This may have been due to the high levels of stock, however, during the last six months these stock levels have started to decline. A small increase in demand could lead to a significant re-rating.

Copper LME warehouse levels - 5 yr - source infomine

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Source: infomine.com

 

Precious Metals – supply

The precious metals complex is dominated by Gold and 2013 has been a difficult year for the “Gold-bugs” as central banks continue adding liquidity but gold prices fail to respond. So much has been written about this subject that I feel I can add little to the debate except to note that the disparity between paper gold (ETFs and Certificate) appear to be at an unusually large discount to physical gold – especially in India and China. For more insights into the arcana of the gold leasing market, I refer you to an excellent article by Gold Money’s Alasdair Macleod – There’s too little gold in the West –  published by the Cobden Centre: –

http://www.cobdencentre.org/?s=There+is+too+little+gold+in+the+West+

Here is his typically bullish dénouement: –

Bearing in mind Veneroso’s conclusion in 2002 that there must be 10,000-15,000 tonnes out on lease and loan from the central banks at that time, one could imagine that this figure has increased significantly. Officially, the signatories of the Central Bank Gold Agreement, plus the U.S. and U.K. own 20,393 tonnes. A number of other central banks are likely to have been persuaded to “invest” their gold, but this is bound to exclude Russia, China, the Central Asian states, Iran, and Venezuela. Taking these holders out (amounting to about 3,000 tonnes) leaves a balance of 8,401 tonnes for all the rest. If we further assume that half of that has been deposited in London, New York, or Zurich and leased out, that means the total gold leased and available for leasing since 2002 is about 12,000 tonnes. And once that has gone, there is no monetary gold left for the purpose of price suppression.

Could this have disappeared since 2002 at an average rate of 1,000 tonnes per annum? Quite possibly, in which case, the central banks are very close to losing all control over the gold price.

Meanwhile the trend continues lower.

Gold

Gold - 2yr chart.

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Source: Tradingcharts.com

Agricultural commodities – supply

With the agricultural sector demand is broadly constant although secular trends such as China’s increasing consumption of meat are structurally important. Within the agricultural sector I will review Wheat, Corn and Soybeans. No pork bellies, frozen concentrated orange juice and none of the softs – not because these markets don’t matter but in the interests of brevity.

In June 2013 the Food and Agriculture Organisation (FAO) published their long-term forecast for agricultural production.  Here is their press release: –

Global agricultural production is expected to grow 1.5% a year on average over the coming decade, compared with annual growth of 2.1% between 2003 and 2012, according to a new report published by the OECD and FAO today.

Limited expansion of agricultural land, rising production costs, growing resource constraints and increasing environmental pressures are the main factors behind the trend. But the report argues that farm commodity supply should keep pace with global demand.

The OECD-FAO Agricultural Outlook 2013-2022 expects prices to remain above historical averages over the medium term for both crop and livestock products due to a combination of slower production growth and stronger demand, including for biofuels,

The report says agriculture has been turned into an increasingly market-driven sector, as opposed to policy-driven as it was in the past, thus offering developing countries important investment opportunities and economic benefits, given their growing food demand, potential for production expansion and comparative advantages in many global markets.

However, production shortfalls, price volatility and trade disruption remain a threat to global food security. The OECD/FAO Outlook warns: “As long as food stocks in major producing and consuming countries remain low, the risk of price volatility is amplified. A wide-spread drought such as the one experienced in 2012, on top of low food stocks, could raise world prices by 15-40 percent.”

China, with one-fifth of the world’s population, high income growth and a rapidly expanding agri-food sector, will have a major influence on world markets, and is the special focus of the report. China is projected to remain self-sufficient in the main food crops, although output is anticipated to slow in the next decade due to land, water and rural labour constraints. 

Presenting the joint report in Beijing, OECD Secretary-General Angel Gurría said:  “The outlook for global agriculture is relatively bright with strong demand, expanding trade and high prices. But this picture assumes continuing economic recovery. If we fail to turn the global economy around, investment and growth in agriculture will suffer and food security may be compromised. (Read Mr. Gurría’s speech)”

“Governments need to create the right enabling environment for growth and trade,” he added. “Agricultural reforms have played a key role in China’s remarkable progress in expanding production and improving domestic food security.”

FAO Director-General Jose Graziano da Silva said: “High food prices are an incentive to increase production and we need to do our best to ensure that poor farmers benefit from them.  Let’s not forget that 70 percent of the world’s food insecure population lives in rural areas of developing countries and that many of them are small-scale and subsistence farmers themselves.”

He added:  “China’s agricultural production has been tremendously successful. Since 1978, the volume of agricultural production has grown almost five fold and the country has made significant progress towards food security. China is on track to achieving the first millennium development goal of hunger reduction.

While China’s production has expanded and food security has improved, resource and environmental issues need more attention. Growth in livestock production could also face a number of challenges. We are happy to work with China to find viable and lasting solutions.” 

Developing countries to gain

Driven by growing populations, higher incomes, urbanization and changing diets, consumption of the main agricultural commodities will increase most rapidly in Eastern Europe and Central Asia, followed by Latin America and other Asian economies.

The share of global production from developing countries will continue to increase as investment in their agricultural sectors narrows the productivity gap with advanced economies. Developing countries, for example, are expected to account for 80 percent of the growth in global meat production and capture much of the trade growth over the next 10 years. They will account for the majority of world exports of coarse grains, rice, oilseeds, vegetable oil, sugar, beef, poultry and fish by 2022.

To capture a share of these economic benefits, governments will need to invest in their agricultural sectors to encourage innovation, increase productivity and improve integration in global value chains, FAO and OECD stressed.

Agricultural policies need to address the inherent volatility of commodity markets with improved tools for risk management while ensuring the sustainable use of land and water resources and reducing food loss and waste.

Specifically in the US, droughts and extreme weather conditions have been the principal factors influencing supply. Water remains a scare and undervalued resource but improvements in technology and farming methods are ongoing. Nonetheless, prices for irrigated farm land have been making new highs during the year. Below are a series of Ten Year monthly charts of Wheat, Corn and Soybeans. The price spike of 2008 is evident in each case and the subsequent rally of Corn and Soybeans to make new highs in 2012. However, during 2013, despite another year of droughts, prices have remained subdued. Nonetheless, prices appear to be near to the base of their long-term up-trends.

Wheat

Wheat - 10yr chart

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Source:Tradingcharts.com

Corn

Corn - 10yr chart

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Source: Tradingcharts.com

 

Soybeans

Soybeans - 10yr chart

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Source: tradingcharts.com

The latest USDA reports (December 2013) can be found here: –

Wheat

http://www.ers.usda.gov/publications/whs-wheat-outlook/whs-13l.aspx

Projected 2013/14 supplies are raised 10 million bushels this month to 3,008 million bushels. Production and carryin stocks are unchanged, but imports are raised to 10 million bushels to 160 million bushels with expected higher hard red spring (HRS) and soft red winter (SRW) imports from Canada, up 5 million bushels each.

Corn

http://www.ers.usda.gov/publications/fds-feed-outlook/fds-13l.aspx

Projected 2013/14 corn use is increased 100 million bushels this month, split evenly between fuel ethanol and exports. Margins have been very favorable for ethanol mills, with higher ethanol and distillers’ dried grains (DDG) prices on the revenue side combined with lower corn prices on the input side. Exports have benefitted from lower corn prices and increased global consumption. Increases in use are offset slightly by a 5-million-bushel increase in projected imports. Production and feed and residual are unchanged. Projected carryout is tighter by 95 million bushels, at 1.8 billion bushels, but still double last season’s estimate of 824 million. The 2013/14 season-average farm price for corn is projected 10 cents lower at the midpoint of $4.40 per bushel, with the range narrowed to $4.05 to $4.75 based on prices reported to date.

World coarse grain production for 2013/14 is projected higher this month led by increases for Canadian corn and barley, Australian barley, and Ukrainian corn. Global coarse grain use prospects increase slightly more than production increases, trimming expected global ending stocks.

Soybeans

http://www.ers.usda.gov/publications/ocs-oil-crops-outlook/ocs-13l.aspx

USDA raised its 2013/14 forecast of U.S. soybean exports this month by 25 million bushels to 1.475 billion. Similarly, 2013/14 exports of soybean meal were forecast 250,000 tons higher to 10.5 million short tons, which prompted an expected increase in the domestic soybean crush by 5 million bushels to 1.69 billion. An improved demand outlook lowered the forecast of season-ending soybean stocks by 20 million bushels this month to 150 million. USDA raised its forecast range for the season-average farm price by 35 cents this month to $11.50-$13.50 per bushel.

For Argentina, area reductions for corn and sunflowerseed led USDA to raise its 2013/14 soybean area estimate by 300,000 hectares this month to 20 million. As a result, Argentine soybean production is forecast 1 million tons higher to 54.5 million metric tons. Additional output of Argentine soybean meal may push exports of the commodity in 2013/14 to a record 29.4 million tons. Yet, Argentine soybean stocks could be higher by next September to 28.5 million tons.

None of these forecasts looks excessively constrained and the proximity to trend-line support makes me cautious in the near-term, a breakdown through the ten year up trend could see a retracement of the entire cycle.

A longer term factor which may yet change this dynamic dramatically is the effect of the “Eddy Minimum”.

For some general background on sunspots and climate, this Princeton University website is a useful resource: –

http://www.princeton.edu/~achaney/tmve/wiki100k/docs/Maunder_Minimum.html

The argument in favour of a cooling of global temperature is not new but for the latest comments on this subject the following website is informative: –

http://wattsupwiththat.com/2013/07/24/newsbytes-sunspot-enigma-will-inactive-sun-cause-global-cooling/

Conclusion

Throughout 2013 I waited for a resumption of the commodity bull-trend, expecting that the pick-up in economic activity, combined with the provision of central bank liquidity, would fuel the next leg of the super-cycle. It never materialised. Global growth remained subdued, China switched to a policy of “quality not quantity” and “taper terror” in the US, increased deflation expectations: and revealed weaknesses in a number of emerging markets. Even in the agricultural sector, weather related stress failed to materially reverse the downward pressure on prices.

Looking ahead to 2014 I can see little reason, thus far, to be broadly long commodities – as mentioned at the beginning I encourage all investors to view each market on its own particular merits. However, just like 2013, I am waiting for bearish sentiment to turn. To misquote St Augustine’s teenage prayer “Give me commodities Lord, but not yet!”

I’ll be back in mid January. With best wishes for the festive season and New Year. Col